If no one wants your pile of booty, perhaps you should try shaking things up  At first blush, that appears to be the strategy behind the proposed remixing of Real Estate Mortgage Investment Conduits (REMICs), as presented in a recent Wall Street Journal article:

I’m gonna shake it up

Once upon a time, Wall Street invented a nifty means of centrifuging, separating, refining off, then packaging and selling the resulting slices.  It was called ‘securitization‘ and everyone everywhere lived happily ever after again.

I’ve invested all our money with Bernie Madoff, honey

Or something like that ….

Debacle, period

Certainly the Journal, which is always skeptical of money-making that doesn’t involve a smokestack industry producing manly products, brings appropriate skepticism to this one:

Some day, son, you too can read the Wall Street Journal.

Wall Street Wizardry Reworks Mortgages

Wizards, as we all know, are not manly men.

Oh no?  I can make your security that big

A new wave of financial alchemy is emerging on Wall Street as banks and insurers seek to make soured securities look better.

That’s full metal alchemy, you know

Regulators are pushing back, saying the transactions don’t have enough substance and stand to benefit bankers and ratings firms.

The popular deals are known as “re-remic,” which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.

The Journal provides a handy graphic:

REMICs REMIX: How a bad bond is rebundled.

Doesn’t sound bad in the abstract; but we’ve seen this movie before, haven’t we? 

And the picture gets no better the second time

A hypothetical example cited in research by Barclays Capital said that a $100 million asset that required $2 million in capital at a triple-A rating may require $35 million if downgraded to double-B-minus. At triple-C, the capital requirement might rise to 100%, or $100 million.

Key to your understanding is that downgrades are not changes in the thing itself, but changes in the observation of the thing.  This is a Schrodinger’s Cat moment: the act of observing changes the thing’s value even if its essence remains unchanged. 

You observing me?  You think that changes me?

Though the essence is unchanged, the value is increased.

In a re-remic, three-fourths of the same asset may regain a triple-A rating, requiring just $1.5 million in capital, Barclays said. The remaining one-quarter may require 100% capital, but the total capital requirement would fall to $26.5 million.

Shake up your booty, and it becomes more tasty

The net result is financial firms’ books look better and they need to hold less capital against those assets, even though they are the same assets they held before the transaction.

Put simply, if value is added through the remixing, there are three possibilities:

1. The restructuring changed the risk profile. 

2. The old assessment was too pessimistic.

3. The new assessment is too optimistic.

Better when it’s green, isn’t it?

Of these three, Theory 1 is positive change, Theory 2 has positive impact, and Theory 3 will only make things worse.  So we’d really like Theory 3 to be false, but as we saw some months back, it’s all too easy for people to believe what they desperately hope should be true.

Hope is not good enough – we need expertise and integrity.  Where will we seek it?  Why, the supposedly independent rating agencies.  (I say supposedly because in a five-part series – Part 1, Part 2, Part 3, Part 4, and Part 5 – we saw the rating agencies cozily symbiotic with their ratees.) 

I can be disinterested if you pay me enough

Meanwhile, let’s examine the parol evidence:

American Equity Investment Life Holding Co. has told analysts that it is considering a re-remic. Recent downgrades of its mortgage bonds overstate their risk by a wide margin, its executives said.

That’s Theory 2 expressed in its quintessence.  And it might well be right – many folks, including me, have suggested that the capital markets’ liquidity shortage had led to a massive over-reserving on these assets. 

Some state insurance regulators worry that current ratings are flawed – perhaps even too harsh – for determining the capital that should back up residential-mortgage securities.

Arr, yer too low-rated, matey!

Another anonymous expression of Theory 2.

But they are chafing at the re-remic strategy. That’s partly because of the fees and partly because re-remics rely on ratings firms – faulted for failing early on to identify problems with mortgage-backed bonds – to rate the new securities.

We do know that a symbiote’s life is not a happy one.

At hearings Wednesday on Capitol Hill focused on the ratings firms, U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, “The credit-rating agencies could be setting us up for problems all over again.”

And I know about being set up for problems

Regulators would like “a lot fewer dollars” paid to Wall Street, as well as “less reliance on the ratings agencies,” said Kermitt Brooks, first deputy insurance superintendent in New York. The state is an important voice on financial matters at the National Association of Insurance Commissioners, or NAIC.

Fewer dollars paid is fine if the quality doesn’t suffer, and if you’re not going to rely on the discredited rating agencies, what not-yet-discredited referee are you going to rely on?

The alternative solution, proposed by trade group American Council of Life Insurers, calls for hiring an analytical firm with expertise in residential mortgage-backed securities to help regulators determine the value of deteriorated holdings on insurers’ books, bypassing the ratings providers.

There’s a place for experts who value complex interests.  What will make these postulated new ones any better than the current rating agencies?

It is unclear how big a concern this is for banking regulators. Alabama Deputy Banking Superintendent Trabo Reed said he has seen only a few examples of re-remics.

Is $11 billion ‘only a few examples’?

Wall Street bankers and analysts said a minority of re-remics, perhaps as little as 10% to 30%, are aimed at helping firms like insurers manage capital requirements. The general goal, as one banker put it, is to help “create buyers for orphan securities that otherwise would have languished.”

The issue isn’t why the booty’s being remixed; rather, the issue is whether the remixing is sound or unsound.

“There is $350 billion to $400 billion in market value of securities with no natural buyer due to their rating,” Barclays said in a June report. “The re-remic market provides a way out of this gridlock by creating new AAA securities, which are likely to be viewed as attractively priced.”

We’re only in it for the money

Remixing the booty has a valid regulatory purpose.  Institutions have capital requirements; low-rated securities consume very high capital reserves. 

And Protective Life Corp. said in August that its re-remics, totaling about $1.4 billion, improve the company’s capital standing “in the ballpark” of $75 million.

Getting the securities re-rated, or even re-rating a portion of the securities, adds meaningful value via Theory 1.

Insurance executives estimate that insurers pay 0.35% or so of a deal’s size in investment banking, ratings firm, legal and other costs.

Expressed as a percentage, that’s only 35 beeps.  Doesn’t sound like much, until you multiply it out and its $35 million in fees.

Thirty-five mil!

Pay $35 million, free up $75 million.  Worth it but not by a huge amount.

At an NAIC hearing last week, ratings firms described changes over the past year to improve their analytical, compliance and corporate-governance processes. But they also generally agreed that their ratings weren’t ideal as a sole basis for determining insurers’ capital levels.

In other words, discredited though the rating agencies be, nobody’s offered real competition.

The alternative is to go overseas and get your money from Sheik Yerbouti

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To America, from China — 1922

The Klein-bottle contortions of economic time and space between America and China are explored in an intriguing interview in Seeking Alpha:

The dollar rises in the East? Rick Newman

Think American workers have it bad? It’s worse in China.

I’ve documented this.  China’s property markets are crashing far worse than ours are – and as our recent experience shows, crashing property prices foretell a dramatic economic slowdown.

You may not know that by scanning the headlines. Late last year the Chinese government passed its own stimulus package of about $600 billion, to meet its target of 8% GDP growth. That’s right, 8%. That would be outlandish growth here, where the economy is now shrinking, not expanding.

But in China, that’s barely enough to keep a restless workforce employed. And the government might not be able to make its 8% target. Unemployment is soaring, and there’s even a possibility that economic woes could lead to angry public protests like those that preceded the 1989 Tiananmen Square massacre.

There was a flicker of decency … and then there was a massacre

Since Tiananmen, America and China have become deeply linked to each other.

In the 1960s, I remember a Piet Hein grook:

Coexistence/ Or no existence

Piet Hein: lived to be 91

Although he was speaking of geopolitics, the principle applies equally well to geo-economics.

Americans, obviously, buy a huge amount of imported Chinese goods—about $340 billion worth in 2008.

That’s a lot even in Obama-budget-deficit terms!

Much of the cash that flows back to China gets invested in U.S. government securities, which helps keep U.S. interest rates low.

As I pointed out in Filling a Sieve, capital cycles, and as we’ve seen in Slums: a wealth-extraction machine, capital always finds its best investment, and communities need continuous capital reinvestment.

I hold trillions of your paper in my red-gloved hands

That’s happening now with China, either in our debt or in equity:

China even invests directly in American firms. In 2005, Chinese computer maker Lenovo (LNVGY.PK) bought IBM’s PC division for $1.75 billion. In 2007, the Chinese government bought a $3 billion stake in the Blackstone Group, the American private equity firm.

We Americans have a habit of selling at the top J.

Historian Niall Ferguson, author of The Ascent of Money, even conflates the two nations as one: Chimerica.

Niall Ferguson at Harvard Commencement

Since the two countries are so closely linked, I asked Wei Li, a business professor at the University of Virginia’s Darden School of Business who also teaches at the Cheung Kong Graduate School of Business in Beijing, for an update on the Chinese economy, and how changes there are likely to affect the United States.  Excerpts:

How is the global recession affecting China?

The outlook for China is very grim. Much more grim than for the United States. There are two main drivers: Housing and exports.

Ten years ago there was a housing shortage in the cities. But now there’s a housing glut.

The glut exists at the market’s top end – affordability remains an enormous challenge.

One reason is there’s very little opportunity to invest elsewhere. That led to lots of speculation. It’s mostly urban. In rural areas, you still build your own house.

In rural environments, housing can be created without money, because land has minimal cash cost and you can use found materials and your own labor to build it.  Urban housing always costs money – and as we’ve seen before, the richer the society, the better its housing finance ecosystem, the longer the chunk of our future we’re willing to pledge in order to secure the home that we want.

Is the housing bust in China worse than in the United States?

Housing in China is a much bigger deal than in the United States because people just started buying. For many Chinese they were first-time homeowners.

\When tenure options are limited and housing is in short supply, such is our lust to own a home that we over-reach – and the tighter the supply, the greater the over-reach.

Prices haven’t really fallen yet, but they have to.

If they don’t let prices fall, something else has to adjust. Either the price falls or quantity adjusts. If the quantity goes to zero, nobody buys refrigerators or tiles, or hires electricians or architects.

We have to keep supply and demand in balance

The bust has been going on about one year now, and accelerated since the last quarter of 2008.

A housing price bust always precedes a big economic contraction.

Cut housing prices and watch demand shrink

What about exports?

There’s been a double digit decline. For every 1% rise or drop in U.S. consumption, Chinese exports go up or down by 10%. The effect is 10 to 1.

So with consumption down in the U.S. by about 2% or 3%, you mean that exports in China have fallen 20% or 30%?

That’s right.

Couldn’t keep up the payments

If exports are dropped, the Chinese economy will slow, and if that happens, then Chinese unemployment will rise, and with it Chinese unrest.

The unemployment rate in the United States is 8.1% right now. Is it higher in China?

According to Chinese Academy of Social Sciences (CASS), the unemployment rate in urban areas in the end of 2008 was 9.4%, significantly higher than official jobless rate of 4.0%. It’s probably higher now, since the Chinese economy experienced a marked slowdown since the last quarter of 2008. In addition, in 2009, 6.1 million college graduates are looking for jobs. These figures all underestimate the severity of unemployment in China. The unemployment stats count only jobless rate in urban areas. When rural migrants cannot find jobs, they often return home and subsist on their land.

To keep people employed, China will need to keep exporting – which may mean it’ll keep buying dollars to keep the American economy humming, so as to keep consuming the goods on which Chinese prosperity depends.

Will I keep buying your paper?  That depends, mon capitaine

Can’t the Chinese government pull the old levers of a command economy, crank up spending, and keep people employed?

That’s what people may think, but the Chinese economy is so much bigger than the government can control. If you think U.S. consumers are scared, Chinese consumers are equally scared, if not more. Stocks in China are down 60%. The new middle class who owns multiple apartments is living on a lot of borrowed money. They’re in very bad shape.

As an asset class, housing is the most resistant to price drops … but in turn, that means people become economically immobile as they cover their housing-consumption-cost deficits.

At least I’ve got security of tenure

Houselocking is a real phenomenon, one that will complicate the world’s recovery.  Rental flexibility is a strategic national resource.

Some people worry about the fact that the Chinese government owns several trillion dollars worth of U.S. government securities. You know the argument: If the Chinese sold their holdings the U.S. economy would collapse.

For the Chinese to sell, who would buy?  American interest rates would rise – and probably, American currency would inflate.  The Chinese hold so many dollars that if they sell too many too quickly, they risk killing the market for their own assets.  They’re caught in their excessive liquidity even as we’re caught in our excessive illiquidity.

Maybe I’ll even buy your uniforms, Jean-Luc

China could conduct economic warfare against America. People worry about China buying Treasuries, but for China, they don’t have a choice. There’s really no place else they can put their money. To say that China is somehow controlling the U.S. economy is laughable.

Pretend for the moment that China and America were two adjacent US states.  The one with excess liquidity would be desperately looking for a place to invest; the one with illiquidity would be desperately seeking capital.

Each of us complements the other

In global terms, China has no potential investment partner other than the US remotely close in scale and attractiveness.  And we have no liquidity provider other than China remotely close in scale and attractiveness.

Can it be that I need you, mon ami?

We need each other, whether we like it or not.

So with China in tough shape, will Chinese influence fade?

I think Chinese influence will still grow, but it has to be different. The Chinese approach used to be, speak softly and make a lot of money. That’s not working any more. The system is flawed. If China wants to continue to benefit from globalization, China needs a voice.

Might the best economic safety be rational interdependence, where each of us is stronger when the other succeeds, and each of us relies on all of us acting in our rational self-interest?

Or am I being Pollyanna?

As Star Trek’s Q himself said, “You don’t get it, do you?  The trial never ends.”

“See you around – out there!”

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Securitization, that creature of the early 1990’s, has wrought new changes in our marketplace, none more timely now than the discovery that when a loan goes upside down, the untangling of securitized positions is hideously more difficult than before. 

I can’t see any alternatives

In fact, because the financing quilt is so patchwork, we have the remarkable spectacle of the creditors fighting not with the borrower but among themselves –

So often am I overcome by emotion

– as illustrated in this Wall Street Journal article whose title is so inescapably obvious that I stole and replicated it for this post:

Hancock at Center of ‘Tranche Warfare’

In Boston, John Hancock Tower is at the center of a fight among a group of lenders and investors, just two years after private-equity firm Broadway Real Estate Partners bought the iconic office building with help from some of the biggest names on Wall Street.

Supporting a capital stack that reaches to the sky?

Earlier this month, a Broadway fund defaulted on $700 million of debt tied to the Hancock tower and other buildings.

Default is the starting bell.

Time to fight about control!

Until there is a default – technically, until a default is declared – then the sponsor has control of the property’s operating and financial decisions.  That’s optionality – the power to make choices that will influence a valuable asset.  Sponsors have the optionality because their hard equity puts them in the position of taking first loss.

When the sponsor defaults, however, it means that the equity is gone – at least potentially all gone – and therefore that somebody in the capital stack is exposed to loss.

I’m feeling both exposed and chicken …

That sets off a food fight:

Who’s in charge here?

The default triggered a scramble among investors holding debt tied to the acquisition, with some pushing for immediate foreclosure and others pushing to extend the loan in hopes of a real-estate rebound.

Who’s most stubborn?

Why would some want foreclosure, others want delay?  Very simply, because some think they’re in the lifeboat (fully collateralized) and others behind them in the queue think they’re headed for the icy waters:

Some of you will be left out of the money

The commercial real-estate sector has endured plenty of previous busts. But the fallout is likely to be different this time because of all the debt structures developed in the past decade that have never had to ride out a downturn.

The Journal is right; this time is different.

This time it’s personal

Some $700 billion in debt was carved up into commercial mortgage-backed securities, or CMBS, and sold to investors. Another $50 billion to $75 billion of loans were sold as mezzanine debt, which fills the gap between the mortgage and a borrower’s equity. Like CMBS, mezzanine debt was often sliced and diced into many pieces with varying degrees of risks.

The legal system that governs default-enforcement imagines that capital sits in a simple vertical stack where each layer (from lowest and most senior to highest and most junior) is distinct from the one below and held by an individual counterparty (investing lender). 

In the middle column, the senior lender is the ‘hard’ debt, and the junior is behind and ahead of the equity

Our lender-protection contractual standards (and our bankruptcy jurisprudence) divide debt holders into two groups: those (called ‘money-good’ in the parlance) whose loan can be fully repaid on a sale at the property’s value, and those (’out of the money’) who will suffer a partial or complete loss upon immediate sale.  (A primer on who’s-who is here.)

This system, developed over several generations of previous credit crunches, works well when each tranche of debt is a unitary counterparty – a single holder who can act or not. 

Today’s tranches, though, are not unitary counterparties – the tranche may be pledged or sliced into pieces each of which is held by a different and divergent entity.  (Imagine our horizontal layer of debt being sliced vertically into several pieces side by side.)

“Tranche warfare is starting,” said John Zizzo, a real-estate lawyer at Cadwalader, Wickersham & Taft LLP, referring to the loan “tranches,” or slices, that investors own.

Zizzo, ready to fight in the tranches

Indeed, in today’s world almost every horizontal level of debt has been so sliced, either directly or indirectly (via CDO’s and so on).  That slicing is securitization, and it’s the new element introduced since the last major credit crunch, in 1990. 

“It has never been tested before this current market meltdown.”

With securitized debt, the counterparty is not unitary but fragmentary, even atomized – it’s scattered to the four winds (literally; many securities are owned by offshore investors) and some elements may even have been lost. 

So who’s in charge?

We wanna know but we’re not happy about it

The disputed $700 million of debt in the Hancock battle is mezzanine debt that was divided up among nine investors. With real-estate values declining, not all of the investors would be paid off in a liquidation.

As a result, investors who believe they would be in the money are pressing for an immediate foreclosure, according to people familiar with the matter.

What a surprise!  Those who could be fully paid want to be fully paid now.

We’re tired to waiting to get out of this financial vehicle

Such investors include Five Mile Capital Partners, led by former real-estate financier Steven Baum, and Normandy Real Estate Partners, founded by property investor Finn Wentworth. Mr. Wentworth also is a founder of the New York Yankees’ YES Network.

Investors likely to lose out in foreclosure want to give Broadway more time to repay the loan.

What a shock!  Those who would lose money want everybody to take more risks to increase the property’s value.

Among those investors is a BlackRock Inc. fund run for outside investors. That fund owns the riskiest slice of the loan.

What makes this delicious, at least to an innocent bystander, is that the warring factions are conceptually on the same side of the table.  They’re all capital providers, not capital consumers, and they all want to be paid, even as none of them wants to drive the bus.

Also involved in the scrum are Chicago developer John Buck, who owns the most senior portion of the debt; the RBS Greenwich Capital unit of Royal Bank of Scotland Group PLC; Lehman Brothers Holdings Inc.’s bankruptcy estate; and hedge fund Petra Capital Management LLC, run by Andy Stone, a pioneer of commercial real-estate securities.

We’re prepared to throw mud to get what we want

Mr. Buck is perhaps the cat among the pigeons.  While all the others see the building only as a source of headaches to be endured on the way to money, he sees it as an opportunity to build his business.  Nobody forecloses with quite the relish of a real estate entrepreneur who bought the debt at a discount.

Tastes better because it was bought at a discount

Complicating things further, State Street Corp. inherited stakes in two tranches from Lehman Brothers, according to a person familiar with the situation.

Translation: I’ve arrived late and don’t know anything, but I think you need my consent, don’t you?

I may look diffident but I’m hard to expel

The failed investment bank had pledged the loans to State Street as collateral for a short-term “repo” loan. State Street seized the collateral after Lehman filed for bankruptcy.

Remember Hank Paulson’s joke about himself being the dog that didn’t know what to do after it caught the bus?  Hel-lo, State Street.

These investors had hoped to make fast money on debt tied to the $3.3 billion acquisition, which included the John Hancock Tower and six other properties.

The mezzanine debt essentially was a one-year bridge loan with two six-month extensions that Broadway planned to pay off with new debt or additional equity.

Short-term loans without a long-term takeout are called bullet loans, bullet as in brain.

In finance, if the borrower makes interest payments, and then the whole sum becomes due and payable at once (a balloon), it’s called a bullet loan. 

This is your equity brain after a bullet loan

When I describe such a loan to neophytes, I bring my finger up to my temple, to show where a bullet points.

Now the thing you have to understand, finance Neo, is how to dodge the bullet.

Bullet loans depend on there being ample liquidity.

The credit crunch and recession have prevented Broadway from raising capital.

Our position is impregnable, sir

My problems come not in spies but in battalions, so even if the credit markets were oopen for business, there’s another problem:

Meanwhile, cash flow from properties has fallen too low to service the mezzanine debt, according to people familiar with the matter.

Uh oh.

When the buildings were purchased, Broadway assumed it would be able to fill the space with tenants paying more rent. But the vacancy rate in the John Hancock Tower has risen from practically zero to 15%.

Double oops.

You can see why a global de-leveraging is like a pileup in slow motion.  Each contraction in money circulating money squeezes down another part of the financial ecosystem, which in turn shrinks the money circulating to buy or rent or finance or invest in things.

The mezzanine debt was supposed to deal with such a scenario.

Under bankruptcy law, a money-good lender can be compelled to stand still, so as to prevent that lender from inflicting collateral damages on those junior security holders.  That principle – wait if you’ve covered, gain rights if you’re exposed – works well when the capital is in single layers, so we can determine precisely who stands where.

In case of default, creditors would conduct an appraisal to determine who was in the money and who wasn’t. Terms of the agreement call for the most junior creditor still in the money to be the “controlling holder.” That creditor gets to decide whether or not to foreclose.

Who’s the controlling holder?

Nice idea, but …

According to people familiar with the matter, Five Mile and Normandy believe that they are the controlling holder and are moving to hire a special servicer that would launch a foreclosure proceeding. That move is expected this week. A joint venture led by the two firms bought the debt in mid-2008 at a discount from Lehman and RBS with seller financing.

When the counterparty is dispersed, the multiplicity of holders means that no one is in charge, leaving the loan servicer compelled to do what the documents say.  And the documents say enforce all your rights, waive none of them.

So somebody is likely to start foreclosing on the sponsor, and somebody else is likely to sue to enjoin the foreclosure.

But other creditors are arguing over the appraised value and who is in control, according to these people. They may go to court to try to block the foreclosure action.

Meanwhile, the lawyer’s meters turn …

They call it a bank of electric meters because there’s one fast-turning meter for every bank!

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Yesterday, using a New York Times article as a springboard, we examined Humpty Dumpty’s question of value: what does value mean, and who decides that it means that? 

“Everything’s coming up roses”

For reasons I listed yesterday, the assets are often valued by people who have a vast vested interest in seeing them not fall in value:

Worldwide, banks have written down the value of assets by $380 billion, as high-flying markets have crashed back to earth. Some banks suggest that the write-downs have been conservative and that some assets may be written back up in the future.

They may be right.

Others say the bill will keep mounting.

They may be right.

Pick a card, any card

Bankers like to say that valuing complex investments is part art and part science, but four large firms have said recently that some employees have not been honest.

Pfui, as Nero Wolfe used to say. 

Don’t talk nonsense

It has nothing to do with art, and everything to do with judgment.  That rare commodity.

I don’t know much about art …

In February, Credit Suisse found a group of employees who had bumped up the value of mortgage assets by $2.65 billion during the fourth quarter last year and through the start of this year. The employees were fired.

In March, Lehman suspended two traders on its equity derivatives desk for overpricing bets in the market by tens of millions of dollars.

In May, Merrill Lynch disclosed a similar incident that cost it about $18 million.

Morgan Stanley was the latest to find misconduct. On Wednesday, the investment bank said it had lost $120 million this year because of a rogue trader. The trader, Matt Piper, is British and has worked for Morgan Stanley in London for four years. He was suspended while Morgan Stanley continued investigating his trades in credit-index options.

Do I look like a rogue to you?

“In this sort of environment of stressed markets, one would expect to see people trying to behave improperly,” said Colm Kelleher, Morgan Stanley’s chief financial officer, on a conference call.

“We’re very angry about it.”

Well said on both counts.

Let us show you how we feel

Now, bank executives are increasingly scrutinizing their employees and trying to catch them if they are too optimistic — or downright dishonest — about valuations.

But it is not simply a question of catching rogue traders. Marking the book, as the industry calls the pricing process, has become one of the more controversial topics among finance executives, even in instances where no fraud has been alleged.

Away from Wall Street, plaintiffs’ lawyers are circling.

Did a bank just die?

Suits over losses in funds like Charles Schwab’s YieldPlus Select assert that managers were irresponsible in not knowing how risky the mortgage assets would turn out.

When in doubt, sue.

A spokesman for Charles Schwab said the company does not comment on pending legal cases.

“I don’t know if I could tie it to some kind of widespread conspiracy. Certainly the fact that the write-downs have been so massive would mean that somebody was optimistic,” said Ryan Bakhtiari, a lawyer who has filed an arbitration on behalf of investors against Schwab. “It was true from the beginning to the end of the food chain: everybody made inflated money.”

Now that the inflationary strategy has collapsed, might ultra-conservatism be in vogue?

Free your balance sheet, and the rest will follow

Banks are sometimes forced into write-downs because of selling in the market.

This kind of downward pressure is a reason that some, like me, think there ought to be some ability to leaven current-market results with an assessment of intrinsic value. 

Lehman Brothers, for instance, said that the collapse of the hedge fund Peleton Partners in February forced Lehman to write down the mortgage assets it owned similar to ones held by Peleton. 

Instability headed this way

In an earlier blog post, we saw that in March, the price of Fannie/ Freddie securities – for this purpose, consider them risk-free even though they aren’t – had plunged simply because of a short-term excess of sellers over buyers.  Sellers needed liquidity and were selling Fannie/ Freddie not because they were bad objects, but because they were good objects.

Aren’t I a good object?

Some banks say the write-downs caused by fire sales may be overkill.

“There is a bit of this atmosphere that says, ‘Let’s just mark it down, no one is going to question it if we mark it down,’ ” said Christopher Hayward, the finance director at Merrill Lynch, at a recent industry conference.

Not all banks are eager to take their hits.

No bank is eager to take a hit.  Some banks just decide that pain all at once is better than paint protracted.

Get it over with, okay?

In the fall, for example, a large city in the Southeast asked Bank of America to write down the CDO’s the city held, said Mr. Bakhtiari, who represents the city but was not authorized to identify it.

Bank of America refused to mark down the CDO’s, Mr. Bakhtiari said, because it did not want to create a mark-down domino effect in its other holdings.

I have no idea whether Bank of America was right or wrong, but domino effects are not rational, especially when one seller moves for reasons specific to the seller and not the assets. 

A spokesman for Bank of America declined to comment Thursday.

Investors are increasingly complaining that banks have become too opaque about the assets they own and the trades that make — or lose — them money.

Here lies a glimmer of light.  Although in the end, assets may be worth “what I say they are worth,” if that’s so, the valuing bank ought to make its reasoning visible to its investors.  The investors may choose, as perhaps they should choose, to rely on their bankers, but at least they will no longer be flying blind. 

Returning to Alice the auditor and Humpty Dumpty the investor:

And if you take one from three hundred and sixty-five what remains?”

“Three hundred and sixty-four, of course.”

Humpty Dumpty looked doubtful. “I’d rather see that done on paper,” he said.

Alice couldn’t help smiling as she took out her memorandum book, and worked the sum for him:

365
    1
—-
364
—-

Humpty Dumpty took the book and looked at it carefully. “That seems to be done right–” he began.

“You’re holding it upside down!” Alice interrupted.

You can check my math!

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The louder I shout it, the truer it must be!

That, more or less, is the defense offer by Bear Stearns as to the value of enormous pools of highly structured complex instruments on their books, a declaration so patently self-serving and self-interested that, with Bear now absorbed into JPMorgan Chase, those who depended financially on Bear are taking the opportunity to look at freeze frames of those crucial decisions:

Are you sure you had no better alternative right then?

As reported by The New York Times:

How much is your investment worth?

That might seem like a simple question on Wall Street, where the price of everything from Apple to zinc flickers across computer screens every day. But inside Bear Stearns, the answer was anything but clear last spring for investors who put their money into two giant, but ultimately doomed, hedge funds.

We thought it was safe when we boarded

In hindsight, all decisions are simple, all outcomes inescapable.  Hindsight bias – post hoc, ergo propter hoc – is all too common in human affairs.

Two executives who oversaw the funds, Ralph R. Cioffi and Matthew M. Tannin, did not disclose that the funds were plunging in value until it was too late, the authorities say.

Why didn’t you tell me this before I got on?

On Thursday morning, the pair surrendered to federal agents and were charged with nine counts of securities, mail and wire fraud.

Cioffi and Tannin do their best to look innocent while being perp-walked

Let’s leave aside both the melodrama of perp-walking people who turned themselves in to be arraigned, and make no presumption one way or the other regarding Mr. Cioffi’s and Mr. Tannin’s culpability or innocence.  Rather, let’s examine:

… one of the most vexing problems confronting Wall Street as the credit crisis plays out: How to value tricky investments linked to subprime mortgages and other risky debt.

Why is this hard?  Several reasons:

‘What is value?’ asked jesting Pilate.  Is a thing worth only what you could trade it for right this instant, or is there a ’shadow’ or ‘intrinsic’ value that acts as a lodestar around which the trading prices orbit?

“There’s almost a definitional issue of what you mean by value,” said Rick Antle, an accounting professor at the Yale School of Management. “You’re really kind of behind the eight ball.”

As Humpty Dumpty put it crisply in Through the Looking-Glass:

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”

“The question is,” said Alice, “whether you can make words mean so many different things.”

“The question is,” said Humpty Dumpty, “which is to be master — that’s all.”

There’s no consensus about what ‘value’ means, and as FAS 157 and its progeny work through the system, that problem with definition is wreaking havoc.

Lack of continuous trading.   These assets are originated, placed, and then held.  They do not trade continuously. 

Financial companies flocked en masse in recent years to trading assets that are far harder to value than, say, shares of Microsoft.

Trading is important not just because it creates a continuous curve rather than a series of data points, but also because trading means more eyeballs on the assets, and therefore the wisdom of crowds can be brought to bear.

Wisdom in there somewhere

The level of losses industry-wide is sure to raise questions about how values were assigned in the first place. Banks generally look at prices in the market first. But when no market price is available, they turn to internal computer models. The practice is similar at hedge funds, though in some instances, banks give pricing out to hedge funds, allowing price levels to trickle through in nebulous asset classes like mortgage bonds.

(But remember, the observant herd sometimes stampedes …)

We lost confidence in the dormouse who got us into this

Uniqueness.  Our best means of deciding something’s value is paired comparison: this is better than that, but worse than the other thing.  When the number of dimensions of difference exceeds the number of objects in the trading universe, it becomes impossible to reach a definitive conclusion as to which is better – which is why everybody buys some assets sometime.

“Everybody falls in love somehow.”

Different computers models often use different data and produce different valuations. Investors have complained recently that Wachovia and Washington Mutual are modeling values with a housing price index that is more optimistic than the index used by their competitors.

Complexity.  The more complex an asset is, the fewer people are actually capable of understanding it and thus having a meaningful opinion.  (We can always get meaningless opinions, but they detract from rather than add to the wisdom involved.)

It’s really easy, just follow the directions

On Thursday, the chief financial officer of Citigroup said the company would use internal models to price mortgage bundles known as collateralized debt obligations rather than use the dismally low market prices as the only factor. On the other end of the spectrum, firms like Goldman Sachs say that market prices should be the driving factor in pricing.

Volatility.  Assets that involve multiple layers of leverage, or have a derivative aspect from securitization, can go through wide fluctuations in notional value.  They’re designed to do that, in fact – that’s where big wins come from.  The volatility means that even if a holder would never actually trade the asset at its down price, it could display a down price at an awkward time – like, say, the day Bear went bust.

I WISH YOU HADN’T SNAPPED ME JUST NOW

All these factors play out in the Bear pools:

As the mortgage market slumped last spring, authorities say, Mr. Cioffi valued one of his funds as having lost 6.5% in April. But colleagues at Bear placed far lower values on investments in that fund. They said the fund had lost 18.97%.

BY itself, this is neither shocking nor necessarily criminal.  Those who marched Messrs. Cioffi and Tinnan into their vehicles will have to show not only that they were wrong, but that they were consciously wrong, and did so with intent to defraud.  Tough standard.

“If your securities were something kept in your wife’s refrigerator, what would they be?”

Still, it’s a data point: somebody thought Mr. Cioffi’s fund had dropped three times as much as he thought. 

No, man, it’s all kewl

And the problem may be exacerbated by the way traders are compensated. Bank employees from lowly associates to chief executives are paid bonuses each year based on performance. But there is little recourse if their bets lose money the following year, so long as the employee is deemed to have made an innocent mistake.

Long ago, I pointed out, in Fannie Mae changes how it pays people, that compensation incentives skew executive behaviors.  You’d think that would be obvious.

A bargain at any price!

Some banks are considering expanding the period in which traders are evaluated to longer than a year, said Chip MacDonald, a partner in the capital markets group at the law firm Jones Day.

The problem with using Mr. Cioffi’s valuation lies in human psychology.  He bought ‘em, he’s likely to see them more favorably than others would (or than the market would).  As against that, he’ll know the assets better than anybody else, and care about them more.  He’s the most qualified, in short, but horribly biased.

“It’s a humongous problem for Wall Street,” said Michael Young, a lawyer with Willkie Farr & Gallagher. “These days these valuation obstacles are at the core of the write-downs.”

Humongous problems ahead?

As I’ve discussed in banking on value, there are plenty of sound reasons for using internal valuations rather than relying on trading prices for thinly-traded complex instruments.  Yet who evaluates the evaluators?

Uniformity is our watchword!

[Continued tomorrow in Part 2]

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